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Summary

  • Dividend yield of 4.5% and healthy payout ratio of approximately 65% limits downside to stock price.
  • Company’s aggressive efforts to strengthen smokeless product portfolio will benefit future performance.
  • Lower tobacco grower buyout expenses and consistent price increases will positively affect MO’s EPS.

As tobacco companies offer high dividends, they have stayed the preferred stock of choice among dividend investors. As tougher regulations, higher taxes and increasing acceptance of alternate tobacco products have adversely affected the sales volume of the industry, companies are relying on price hikes to support top-line growth. Altria Group (NYSE:MO) is the leading tobacco company in the U.S. The company recently reported a satisfactory financial performance for 2Q14, despite the challenges faced in increasing volumes. The company has been making efforts to offset the impact of sales volume decline by increasing prices and strengthening its smokeless product portfolio. MO recently raised its low end of EPS guidance for 2014, which provides confidence and visibility of earnings. Also, the company offers a high dividend yield of 4.50%, which makes it a good investment option for investors.

Financial Performance
MO reported a satisfactory financial performance for 2Q14. The company's smokeable segment's revenues increased modestly by 0.8% and adjusted operating profit was up 3.6% year-on-year. MO's reported sales volumes were down 5% year-on-year, mainly due to an overall decline in the industry and inventory movements. On an adjusted basis, sales volume for the company was down 4%, better than the industry average of -4.5%. As MO's sales volume outperformed the industry's volumes, the company enjoyed a retail market share increase of 0.30%.

Despite the sales volume decline, the segment's top line grew modestly, driven by approximately 6% in price increases. Price increases have remained a popular tool in the hand of tobacco companies to offset the weak sales volume and grow top-line numbers. I believe a 6% price increase by the company for 2Q14 is slightly aggressive, and MO will be able to consistently increase prices in a range of 4%-5%. Also, continued price increases have been helping the company grow its margins despite the weakness in sales volume. The company's smokeable segment's EBIT margin increased to 44.2% in 2Q14, as compared to 43% in 2Q13. The company's smokeless segment experienced a revenue increase of 0.70%, driven by a volume increase of 1.6%. Also, the Copenhagen brand enjoyed a retail market share growth of 1.5%, whereas Skoal experienced a 1.1% drop in retail market share due to competitive activities. Moreover, the smokeless segment's EBIT margin increased by 1.5% year-on-year to 66.6%.

Stock Price Catalysts
As the sales volume for cigarettes is on the decline, MO has been aggressively working to strengthen its smokeless tobacco products portfolio, including e-cigarettes. The company started a national rollout of its e-cigarettes in June. So far, the company has rolled out its e-cigarette brand to 25 western states and 60,000 store locations, which represent approximately 70% of the volume in the western U.S. Also, the company expects to expand the distribution of e-cigarettes in eastern U.S. this fall. MO is making efforts to make its supply chain efficient to avoid supply disruptions.

I expect MO to continue to roll out its e-cigarettes with its MarkTen brand, which will support top and bottom line growths and will portend well for the company's long term performance. However, in the short term, I believe continued investments in the MarkTen rollout will weigh on the company's margins. Moreover, I believe the company's MarkTen will be EPS dilutive or will break even, and will not generate profit in the next few quarters. The company reported a loss of $53 million for its e-cigarette business in 2Q14.

Moreover, the company has been consistently sharing its successes with shareholders through dividends and share repurchases. MO currently offers a high dividend yield of 4.5%, which I believe is safe, as it is backed by its free cash flow yield of more than 6%. Also, the company has been aggressively undertaking share repurchases to fuel its EPS growth and magnify ROE. As the company's ongoing share repurchase program is set to expire in 3Q14, the company initiated another $1 billion share repurchase program, which it expects to complete by the end of 2015.

The company also raised the lower-end of its EPS growth guidance from 6%-9% to 7%-9% for 2014, which reflects confidence and visibility of future earnings. The company's earnings are likely to benefit from lower tobacco grower buyout expenses and strong pricing, which will partially offset investments behind the rollout of e-cigarette MarkTen.

Risks

Tough FDA regulations and the imposition of higher taxes pose a risk to the company's top and bottom line growths. Moreover, to offset the impact of weak sales volume, MO has been consistently increasing prices and undertaking share repurchases. As the consumer spending environment remains weak, it might limit the company's ability to consistently increase prices in the future, which will adversely affect the company's top line.

Conclusion
I believe MO is a good investment option for dividend investors, as it offers a high dividend yield of 4.5%. A high dividend yield and healthy payout ratio of approximately 65% limits the downside to the stock price. Also, the company's aggressive efforts to strengthen its smokeless product portfolio will portend well for future performance. Moreover, in the future, lower tobacco grower buyout expenses and consistent price increases will positively affect the company's EPS. However, in the short term, the rollout of MarkTen could put pressure on the company's margins.

Source: Altria: Time To Get Going